Wealthy Real Estate Investors May Feel Biden’s Tax Bite
The White House is eyeing a big tax bite on wealthy real estate investors in Chicago and across the nation, experts say.
Investors are worried about the potential financial impact of the Biden Administration’s plan to change the Internal Revenue Code to help pay for rebuilding America’s infrastructure, improved child care and healthcare for seniors.
The White House is developing a proposal to raise the capital gains tax on real estate to 39.6% from 20% for individuals making more than $1 million a year. President Joe Biden also said he wanted to end another sacred cow—the 1031 exchange—a tax break which allows investors to defer capital gains taxes for decades.
An increase in capital gains for the wealthiest individuals doesn’t mean an end to real estate investment. However, it could result in significantly different strategies, and create an investment slow down with less turnover, experts say.
However, the biggest losers might not only be the fat-cat investors. “The majority of investment transactions are relatively small residential real estate,” attorney Scott A. Johnson, of Eastman & Smith’s real estate practice group, told GlobeSt.com.
“If a property is cash flowing, and has positive equity, an investor will be likely to hold in hopes that the capital-gains rate is reduced in the future,” Johnson predicted.
1030 exchanges explained
The Biden Administration’s plan to eliminate the 1031 exchange would wipe out an estimated $50 billion in tax breaks for investors with a net worth of more than $400,000.
However, an end to the 1031 exchange could likely reinforce an economic slowdown, experts say. Repealing 1031 exchanges could shrink the economy by more than $13 billion, discourage investment and lower tax revenue, reports an Ernst & Young study.
Under Section 1031 of the Internal Revenue Service tax code, sellers of investment property may defer capital gains taxes on the sale by purchasing “like-kind” properties.
Investors utilizing the 1031, or “Starker” exchange have 45 days to identify new investment properties. After the investor closes on the sale of the old property, he or she has 180 days to buy and close on the newly identified property. You could sell an apartment building, then buy raw land, or swap your ranch for a strip mall and pay capital gains taxes down the road.
“1031 Exchanges aren’t just paper transactions involving a single investor looking to defer tax payments,” noted Inland Real Estate Investment Corp. “Instead, the investor is able to use the funds that otherwise would have been earmarked for taxes to make upgrades on the property, diversify holdings, and improve their community.”
Tax loophole: step-up basis
Another threat to real estate investment is the Biden Administration’s plan to end the long-established “step-up” basis. A step-up in basis is the readjustment of the value of an appreciated real estate asset for tax purposes upon inheritance.
The step-up in basis tax provision has often been criticized as a tax loophole for the ultra-rich and wealthy, who take advantage of it to eliminate or reduce their tax burden on their heirs.
When real estate is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. The asset receives a step-up in basis so that the beneficiary’s capital gains tax is minimized. A step-up in basis is applied to the cost basis of property transferred at death.
Tax basis is the amount of a taxpayer's investment in property for tax purposes, typically used to calculate figure depreciation, amortization, and other property dispositions.
For example, let’s suppose an investor bought a loft condo in 2000 for $300,000. When the investor’s son inherited the loft after his father’s death, the loft had a market value of $500,000.
When the son sold the loft for $600,000, his tax basis was $500,000. So, he only paid taxes on the $100,000 difference between the selling price and his stepped-up basis of $500,000.
If step-up in basis didn’t exist, then the son would have had to pay taxes on the difference between the $600,000 selling price and the initial buying price of $300,000.